On May 11, 2009, the Obama Administration (the “Administration”) released the “General Explanations of the Administration’s FY 2010 Revenue Proposals” (the “Green Book”). The Green Book describes several international tax proposals (the “Administration’s Proposal”) that, if enacted, would affect many aspects of U.S. federal income taxation. One purpose of the Administration’s Proposal is to “limit shifting of income through intangible property transfers” and, to that end, it proposes three changes to the transfer pricing rules.
Overview of Proposal
The Administration’s Proposal is intended to “clarify” the operation of the U.S. transfer pricing rules by (1) expanding the definition of intangibles (under Sections 367(d) and 482) to include workforce in place, goodwill and going concern value; (2) authorizing the IRS, where more than one intangible is transferred, to value those intangibles on an aggregate basis, when aggregation would lead to a more reliable result under the commensurate-with-the-income standard; and (3) providing that intangible property be valued at its highest and best use, as upon a sale between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of pertinent facts. These and the other Administration tax proposals were analyzed by the staff of the Joint Committee on Taxation (JCT) in JCS-4-09, issued September 14, 2009, which suggested that further changes to the U.S. transfer pricing rules be explored, including (1) limiting the comparable uncontrolled transaction (CUT) method to situations where there are exact comparables and providing that, in other cases, methods such as the income method that do not depend on comparables be endorsed; (2) having the periodic adjustment rules under the commensurate-with-the-income standard play a more determinative role; and (3) limiting cost sharing to situations where there are comparable arrangements between unrelated parties.
Clarification of Definition of Intangible Property (Administration)
The Administration’s Proposal seeks to resolve issues that have been the subject of audit disputes and proposed adjustments with respect to transfers of intangible property, centered mainly around (1) whether goodwill, going concern value and workforce in place are compensable intangible property, and the reach of those concepts; and (2) the scope of the exception under Section 367(d) for foreign goodwill or going concern value. The Administration’s Proposal would resolve these disputes by providing that goodwill, going concern value and workforce in place are intangible assets within the meaning of Section 936(h)(3)(B), and that work force in place is a separately identifiable asset and, by implication, is ineligible for the foreign goodwill or going concern value exception under section 367(d). However, it is not clear that the categorical exception for foreign goodwill and going concern value under Section 367(d) is intended to remain, especially if the ownership of the foreign goodwill and going concern value can be attributed to a U.S. taxpayer. The JCT believes that if the Administration’s Proposal is enacted, the impact on taxpayers would be an increase in the compensable proportion of the value in many outbound transfers of intangibles as compared to the amount believed by many to be compensable under present law.
The Administration’s Proposal seeks to resolve certain audit disputes with respect to valuation techniques used by taxpayers that transfer compensable intangible assets offshore. The issue is with respect to whether the most reliable valuation technique is to value intangibles individually, on an asset-by-asset basis as taxpayers sometimes contend, or whether this technique fails to accurately and reliably reflect the enhanced valued that arises in some situations from the interrelationship of intangible assets.
The temporary cost sharing regulations effective January 5, 2009, provide for aggregate valuation, the effect of which is a greater buy-in payment (referred to as a Platform Contribution Payment in the temporary regulations). Technical Advice Memorandum (TAM) 200907024 is to the same effect, but officially TAMs cannot be used or cited as precedent. The Administration’s Proposal would officially apply the aggregation concept beyond cost sharing to other transfers of intangibles subject to Section 482 (by way of license) or subject to Section 367(d). According to the JCT, the Administration’s Proposal confirms the IRS position that the enhanced value from the interrelation of intangible assets can be properly attributed to the underlying intangible assets in the aggregate where doing so leads to a more reliable result.
Valuation – Highest and Best Use (Administration)
According to the JCT, the Administration’s Proposal clarifies that intangible property must be valued at its highest and best use, which generally corresponds to the fair market value standard articulated in Treasury regulations under various Code sections and in case law. The application of this principle, however, is not well developed judicially, a fact that the JCT argues could complicate rather than simplify tax administration efforts in some circumstances.
The JCT notes that some commentators have suggested that this part of the Administration’s Proposal is intended to establish legislative backing for the realistic alternative test in the Section 482 regulations, which is particularly prominent when unspecified methods are used to determine arm’s length transfer prices and in the temporary cost sharing regulations.
Limiting the CUT Method (JCT)
With respect to transfers of unique, high value intangibles, rather than permit the use of the CUT method, the JCT proposes legislation authorizing the income method (or other methods that do not rely on comparables) unless there are exact comparables. Since it is rare to find exact comparables, such legislation would largely eliminate the CUT method and replace it with the income method. In this connection, it is noted that in the temporary cost sharing regulations the income method follows from the investor model; in other words, the implication of this JCT suggestion is that licensees’ projected return is to be limited to the return of an investor.
Eliminating the Exceptions to Periodic Adjustments (JCT)
In implementing the commensurate-with-the-income concept added to Section 482 in 1986, the periodic adjustment rule of the Section 482 regulations provides a number of exceptions. The exceptions are both in the general regulation with respect to intangible transfers and in the temporary cost sharing regulations. However, the JCT believes that a more “determinative” role should be given to situations where a taxpayer’s actual profit results significantly vary from the taxpayer’s reasonable profit projections at the time of the initial transaction.
Narrowing the Applicability of Cost-Sharing (JCT)
The JCT also suggests that the Treasury reconsider the appropriateness of the cost sharing framework provided for in the temporary regulations, because there is evidence that such arrangements exist infrequently among unrelated parties. The cost sharing regulations may unintentionally encourage offshore development of intangible property. Thus, it is suggested that Treasury consider a new and more limited framework for cost sharing.